Wolfgang Munchau, in the Financial Times, revives a line of thought that was voiced from time to time during the financial crisis: that some countries (the UK, Germany, the Netherlands, Switzerland) had banking sectors that were so large that it was an open question as to whether they could credibly backstop them. One of the peculiar conventions of modern banking that goes unaddressed post crisis is that the country that is the headquarters of an international financial firm is perceived to be responsible for it. So let us say Citigroup has a run in Europe. That is not the problem of the regulators in the countries in which Citibank does business; Citigroup is expected to supply funds to meet depositor demands, and if they need emergency help to do so, they look to Fed (the other model would be to have any banking operation in, say, Italy, to be subject to national rules regarding capital adequacy, a sort of “each tub on its own bottom” approach).

Munchau explains that when you look at the obligations of various states in Europe and include contingent claims, particularly those issued to banks, the strength of fortress Germany comes into question. From the Financial Times:

Is the eurozone insolvent?…

The first thing to note is that you cannot answer that question with a cursory reference to the debt-to-gross domestic product ratios of eurozone countries. …The problem is that those headline numbers exclude contingent debt and the interconnectedness of financial flows.

The biggest category of contingent debt is made up of the various guarantees the eurozone has been handing out in the last couple of years. European Union governments have effectively guaranteed the liabilities of their entire banking sectors. They have guaranteed all bank deposits up to a certain limit. The eurozone member states guaranteed Greek debt for the next three years, and then extended the scheme to the rest of the eurozone. And those guarantees will probably have to be doubled again….

What is the size of the problem? International Monetary Fund estimates suggest that the eurozone is well behind the US in terms of writing off bad assets. I have heard credible reports suggesting that the underlying situation of the German Landesbanken is even worse than those estimates suggest. Last year, a story made the rounds in Germany, according to which a worst-case estimate would require write-offs in the region of €800bn – about a third of Germany’s annual GDP. If you were to add this to Germany’s public debt, you might jump to the conclusion that Greece should bail out Germany, not the other way round. While that is probably a little exaggerated, there are serious questions about whether the eurozone is still in a position to issue such massive guarantees. So, given what happened to those subprime CDOs, what hypothetical rating should we then attach to that €440bn eurozone SPV? A triple A?….

Of course, another positive exit scenario would be a combination of strong growth and low interest rates – to help the banks generate big profits to allow them to write off their bad debts in small instalments year after year. The Credit Suisse report asked whether the slowdown in global growth might have the same effect on the eurozone that the slowdown in the US housing market had on subprime CDOs. As long as the eurozone governments can generate sufficient tax revenues, all is well. But if that were to stop, the eurozone’s debt edifice might break down like a house of cards. Even a 150 per cent debt-to-GDP ratio would be feasible if the eurozone had an intelligent growth strategy. But it never did, and it still does not.

I make no predictions here. But recent financial history teaches us that we must ask those questions and not blindly trust implausible promises, whether made by bankers or by politicians. I suspect that for as long as those Landesbanken and cajas stay unreformed, investors have good reason to treat the eurozone in the way they should have treated subprime CDOs.

Yves here. The Landesbanken were major stuffees for toxic US debt, in particular, subprime. So the continued wobbliness of the eurozone is in part a lingering aftereffect of the 2007-2008 crisis.